This week, we have another treat for our readers and bring you a chapter from our book on the director's Duty not to Trade Whilst Insolvent. Directors have a duty to prevent the company from trading whilst it is insolvent. They also have a duty not to allow the company to trade in a way that will make it insolvent.

People who have not been in business for long might think that avoiding insolvent trading is an easy task – wouldn’t it be obvious when the company is insolvent? However, this might not be as straightforward as expected. Some companies regularly flirt with insolvency because of the markets they operate in and reliance on extraneous circumstances.

Duty to Avoid Insolvent Trading

The duty and possible defences are set out in s 588G of the Corporations Act. A director might be found to have breached the duty where:

The person is a director;
The company incurs a debt; and
The company is insolvent or becomes insolvent; and
There were reasonable grounds for suspecting that the company was/would become insolvent by incurring that debt

'Incurs a debt'

The meaning of incurring a debt may be broader than many might think - it can go beyond simply owing money. Incurring a debt may include the following:

Paying or declaring dividends;
When the dividend is paid
Making a reduction of share capital;
When the reduction takes effect
Buying back shares (even if the consideration is not a sum of money);
When the reduction takes effect
Buying back shares (even if the consideration is not a sum of money);
When the buy-back agreement is entered into
Redeeming redeemable preference shares;
When the shares are issued
Financially assisting a person to acquire shares in itself or a holding company;
When the agreement to provide financial assistance is entered into. If there is no agreement, the debt is incurred when the financial assistance is provided.
Entering into an uncommercial transaction
When the transaction is entered into

Keep in mind this list is not exhaustive and will depend on the circumstances.

Company is 'insolvent'

By law, a company is deemed insolvent if it can't pay its financial obligations when they become due and payable. It could mean the company's liabilities are more than its assets. A company may also be presumed to be insolvent if it failed to keep financial records or failed to retain records in relation to a period of 7 years.

'Reasonable grounds' for suspecting insolvency

Normally, whether there were reasonable grounds for suspecting insolvency will be the main issue when deciding whether there has been a breach of duty. It will nearly always depend on the specific circumstances of each case.

The High Court has held that a 'suspicion' that insolvency exists is more than a 'mere idle wondering' whether insolvency exists or not. Suspicion is a positive feeling of actual apprehension. Past cases have indicated what is important is how a 'reasonable and prudent man' in a similar situation would be expected to perceive the situation. If it would be obvious to someone in the same shoes as the director that the company was insolvent, then it is likely this will be made out.

Consequences:

Breach of the duty not to trade whilst insolvent can result in the following:

Penalty of up to $200,000;
Disqualification from being a director;
Director may be personally liable to pay debts;
Potential criminal liability (if dishonesty exists)

Next Steps

Directors should actively be aware of and keep an eye on their company’s finances and cash flows. They should monitor the payment of creditors and invoices and the repayment of loans. If something doesn’t look quite right you will need to actively take the steps to address the issue of potential insolvency. Do not attempt to keep running the business with the blind hope the problem will fix itself!

What Should I Do Next?

Contact us if you would like further legal advice while suspecting company's insolvency. Our lawyers at You Legal will be happy to assist you in whatever way we can.

* This blog is for general guidance only. Legal advice should be sought before taking action in relation to any specific issues.

Directors' Duties in Focus - Duty not to trade while insolvent